James Baker has signaled his desire "to hold down interest rates and let the dollar fall," according to The Post. Distinguished economists call for only small cuts in the budget deficit; anything larger could "topple the economy into recession." Martin Feldstein, writing in The Wall Street Journal, says that America should "explicitly but amicably abandon the policy of international policy coordination." Taken together, this advice is a recipe for disaster.
Why? America is living beyond its means. As long as foreigners were prepared to lend massive sums to the United States, there was no problem. But the supply of willing private lenders has dried up. The world's central banks have stepped in to buy up the excess of dollars, effectively printing money to finance the U.S. trade deficit. This cannot continue indefinitely.
But the trade deficit cannot be eliminated overnight. Somebody will have to be induced to lend the United States $10 billion to $15 billion a month for many months to come. The only question is at what price -- in other words, how far the dollar will have to fall and U.S. interest rates will have to rise to rekindle enthusiasm for lending to America.
Many American economists see a simple solution. Let the dollar fall quickly to the "right" level. Then, since foreigners will know that it is at the "right" level, they will start lending to America again.
They are wrong. First, until we know how long it will be before decisive action is taken to cut the budget deficit, nobody knows what is the "right" level for the dollar. If American spending rolls on unchecked, higher inflation will offset the competitive gains from a lower dollar, pushing the "right level" for the dollar farther and farther down. On the other hand, if American spending is cut back quickly, either by budget cuts or by a recession, then the dollar will not have to go much farther down.
Nobody knows which outcome is more likely. What the foreign exchange markets do know is that since 1973 the dollar has been going up and down, each time overshooting the "right" level by increasing amounts. And since last time the dollar overshot upward by 30 percent to 40 percent, it could overshoot downward by a like amount -- which would mean that it still has a hell of a lot farther to fall.
Federal Reserve Chairman Alan Greenspan has inherited an impossible situation. Investors are losing confidence, both at home and abroad, and they are looking to the Fed for diametrically opposite signals. American investors want it to pump money into the economy to stave off recession. Foreign investors want it to let U.S. interest rates rise to defend the dollar and protect the value of their investments.
So far the Fed has steered a fairly skillful course between Scylla and Charybdis. The Sept. 5 discount rate hike helped reassure foreign investors. Aggressive provision of liquidity since Black Monday has helped reassure domestic investors. But now the foreign exchange markets are waiting to see how far the dollar will be allowed to fall before the Fed will let U.S. interest rates rise again -- which could set off another slide on Wall Street.
Baker is an astute politician who is reputed to be a good poker player. He has been playing for time. Trying to prop up the dollar at an unsustainable level gained about six months. Unfortunately, letting it go may not gain more than a few weeks. His hand lacked one key card -- decisive action to cut the budget deficit.
The arithmetic is simple. Both the country as a whole and the federal government are spending roughly $150 billion a year more than they are earning. If America is to stop going into debt for a while, as it should, then the only way to bring spending down in line with income in a controlled and manageable way is to cut the budget deficit to around zero. This need not be done overnight, but should be done over, say, the next three years.
Would this tip the economy into recession -- as argued by many American economists from both ends of the political spectrum? They fail to realize that once the inflow of foreign savings dried up, a recession, or at least a sharp slowdown, became inevitable. They have also not learned a lesson from Europe: when you lose the confidence of the financial markets, Lord Keynes has to be turned upside down.
What this means is that if decisive action were taken to cut the budget deficit quickly, the boost to the economy from improved confidence, lower interest rates and a dollar stabilized at a somewhat lower level would, in a matter of months, outweigh the negative impact of higher taxes and lower federal spending.
The classic example of an anti-Keynesian fiscal policy was Margaret Thatcher's March 1981 budget, which cut the structural budget deficit by 3 percent of gross national product when the economy was already in recession. This prompted 365 economists to write a letter to the London Times protesting that she was committing economic suicide. In fact, however, the second quarter of 1981 was the turning point. Because of Thatcher's draconian budget, the Bank of England was able to pursue an expansionary monetary policy and orchestrate an orderly decline in the pound. And it was the boost from the lower pound and lower interest rates that pulled the economy out of recession.
There is an important lesson here. After the stock market crash in October 1929, governments almost everywhere tried to cut budget deficits, and the Fed pursued a restrictive monetary policy. This, together with Smoot-Hawley and competitive devaluation, led to the Great Depression.
History need not repeat itself. First, the United States should cut its budget deficit so that the Fed can pursue a relatively easy monetary policy, without setting off a free fall in the dollar. Second, other countries with trade surpluses should increase, not cut, their budget deficits. Third, all countries, not just the United States, must not try to opt out of the impending world recession by putting up barriers to imports. Fourth, international macroeconomic cooperation must be strengthened, not abandoned.
The issue now is whether the U.S. trade deficit can be corrected without inducing a world recession. Europe and Japan, with a combined GNP nearly double that of the United States, will have a crucial role to play. Equally, even after America has got its act together, massive international support will probably be needed for the dollar: it is, after all, the world's currency.
The writer is a senior fellow at the Institute for International Economics.